Is the Indian Economy headed towards a Recession?
The title is not designed to shock you into reading this article but to prepare you for the worst that the Indian economy is yet to face. What I am about to put forth is that the recession in India will not be mainly due to the financial crisis in the West but due to local reasons. I believe that the economic problems faced by our country in 1990 and again in 1999 were due to the same reasons. My claim is that India would have gone into recession by 2009 end whether or not there would have been a financial crisis in the western countries. So, here goes:
Hardly 6 months back, in September 2008, the Indian Government was extolling the virtues of the Indian economy with a growth target of 9% for the year 2008-09, having prudently (providentially?) escaped the winds of the financial crisis blowing across the western countries (the reason seemingly being the foresight of nationalizing Indian banks 40 years ago, which, most people at that time rightly presumed was politically directed towards taking control of the resources available to the breakaway faction of the ruling party rather than prudence for the Indian economy!). Industry leaders were gung-ho about the economy and projecting fantastic growth prospects for their firms in the years ahead seemingly due to a decoupled Indian economy.
Let us consider the effects of the International Financial Crisis on India until October 2008: 1) The Indian banks had no exposure to sub-prime assets except for a few hundred crores in the case of ICICI Bank, 2) Drain of foreign investments from the Indian stock markets, 2) Some slowdown in certain export sectors, 3) Nominal reduction in the repatriation of NRI funds from abroad, 4) FCCB was already restricted by the government, so this had no effect.
Although there was a drain of foreign investments from Indian stock markets, an exodus of this scale had occurred many times earlier without any deleterious effects on the Indian economy. This only resulted in a drain of foreign exchange reserves that were fuelling inflation. Moreover, Indian insurance firms and mutual funds were big buyers in the Indian stock markets throughout 2008. Also, the Indian currency was holding strong as yet. Thus, India remained decoupled. So how did the slowdown happen?
The crash in the Indian stock markets in early 2008 led to a substantial reduction in the value of savings in the Indian economy. The reason for this being a substantial reduction was that in the past two years a significant part of the savings had shifted to the stock exchanges due to the phenomenal rise in the stock indices. However, the Indian investors, in the hope that the Indian economy was decoupled and their savings would be safe in the long run, innocently absorbed this loss.
Could all this have caused a slowdown in the Indian economy, or, was it the increased government spending in an overheated economy leading to increased interest rates and drying up of bank funds?
During the period from January 2008 and August 2008, the Indian economy continued to grow at around 9% along with inflation. Reasons for the inflation and growth: 1) Interest rates were still low in early 2008. 2) Consumer confidence was high due to the bright future of a seemingly decoupled Indian economy growing at 9%. The Indian consumers were on a spending spree egged on by a government displaying a decoupled economy with a bright future. 3) Salaries were still growing faster than anywhere in the world. 4) Businesses were doing well because of high inflation.
During this time, however, the fiscal deficit was ballooning, resulting in money being drained away from business into political promotion. With the government having just narrowly survived the withdrawal of the left parties’ support, the stage was set for political expediency leading to increased spending in the economy to boost the ruling parties’ prospects in the impending elections: suicides by farmers had suddenly become important and rural employment guarantee schemes needed increased focus. All this spending needed support from the banks, and who else but the nationalized banks to bank upon!
At this time, also, the Indian economy was facing the supply-side shock of increasing oil and commodity prices. The government absorbed this shock of increasing oil prices to a large extent into the oil companies, which ultimately were government-owned, further increasing the fiscal deficit. Also, in order to control inflation, the RBI kept on restricting the money supply and increasing interest rates until September 2008. All this was leading to a drastic reduction in the money supply. However, even as the money supply was drying up, spending by both the government and the consumers was not declining leading to an increased demand for loans and increasing interest rates. The banks kept on distributing loans until September 2008 when the loanable funds suddenly dried up.
It also appears that the Indian economy was overheated during the first half of 2008, which resulted in a rise in the unit costs of production and wages and labor costs leading to rapidly increasing prices of commodities with cost-push inflation. Hence, the rise in GDP during this period could not be sustained. The other proof of this is that new job seekers were not able to find jobs even in July 2008 due to the saturation of labor in an overheated economy. (In economic terms, an economy cannot sustain production exceeding potential real GDP for prolonged periods without compensating for it later with the actual real GDP declining to its potential level).
Indian SMEs were meanwhile facing the full brunt of this reduction in money supply and the rise in input prices. Also the export-oriented SMEs were facing reduction in demand due to the slowdown abroad. A money-starved SME sector started experiencing a slew of business failures, salary reductions and job cuts.
Meanwhile, ICICI bank, which disclosed around 300 crores in sub-prime investments in September 2008, faced a run on its funds from its customers in October 2008, was the first Indian Bank to face a funds crunch. Also in November 2008, the poster boys of the Indian industry started displaying doubts about the near-future growth prospects of the Indian economy. This happened just a few days after the government itself grudgingly admitted that the economy would grow only by 8.5% during 2008-09. What was particularly noticeable was that the Indian IT firms were clearly able to tone down their projections for the year based on the events unfolding in the US, whereas the local firms seemed be looking towards the Indian government for direction (Indian firms’ projection pronouncements of their performance have always had a noticeable lag to the government’s projections about the Indian economy!).
It was indeed surprising that by November 2008, everything turned topsy-turvy: the private banks started appearing riskier to their customers, while the nationalized banks became safe havens More so because, the government, instead of trying to instill confidence in the Indian public about the safety of the Indian private banks (unlike Satyam which it felt was safe for investors!), rather promoted the diversion of funds towards the nationalized banks (Bank Nationalization II?).
Meanwhile, government spending in the rural areas continued: farm loan wavers and NREGS. Where does all this lead the agriculture sector? Loan wavers and employment guarantee schemes in the rural areas are definitely not motivators of agricultural production! Thus, agriculture growth dips; and will continue to dip with such schemes continuing till the elections. All this diversion of funds to the rural areas is visible with rural India not being affected much by the slowdown. The brunt of the cash crunch is being faced by the Indian SME sector, which is starved of funds, and the corporates ditto due to the increasingly stuck interest rates. It is notable that the funds crunch affects the SME sector more due to the fact that funds availability not only affects the performance of their firms but also their personal pockets, which is not largely the case with corporates.
What are the banks doing under these circumstances? The nationalized banks are creating losses by parking the depositor’s funds with the RBI at a loss in order to feed government spending rather than giving out loans to SMEs and corporates (Bank Nationalization II, definitely!). The private banks having faced a run on their funds have been forced to collect fixed deposit funds at increased rates of interest, and so, are wary of distributing loans into an uncertain and riskier business environment. All this will be visible possibly in the results of the Indian banks for the quarter ended March 2009.
With layoffs being frowned upon, SMEs and corporates are cutting down on business expenditures and cutting and delaying salaries and perks. This ultimately affects personal spending. This also leads to capital and employment destruction. These will slowdown the economy further. Also, sticky consumer prices will hasten the slowdown spiral towards recession. It is notable that there is a long time lag in restarting a closed business or bringing back to normal a business affected by a slowdown.
Any economist will confirm that the increase in the bond yields in the present circumstances is due to increased government borrowing (who expressed surprise at this increase?). It is very obvious that funds are getting diverted for government spending and is not available for capital and personal spending. Hence, interest rates are remaining sticky although the RBI has gone in for rate cuts. (Was someone grinning while reprimanding the Indian banks for not lending despite the RBI reducing interest rates?).
The fact that rural spending is not creating any capital, and hence, will enable employment in the implemented schemes only till the government keeps on spending, forebodes a very gloomy scenario. It would become more and more difficult to increase taxes as the economy deteriorates due to the ballooning fiscal deficit and increased unemployment. So where will the funds for increased spending come from? If they come from a depleting funds pool, interest rates will further increase or remain sticky. This bodes ill for capital spending and employment generation.
It also seems that deflation is upon us. Is this not a sign of impending recession? The government may try to manipulate the figures to keep inflation just positive: 0.31%, 0.26%, 0.18%, or 0.01%. Does it matter? In India, inflation figures are disseminated in wholesale rates! There is a huge gap between the WPI and CPI in the Indian market due to many intermediaries. This is required in order to create jobs in the supply chain (socialism?). So, if for example, the farmer sells onions at Re. 1 per kg, the wholesale price is Rs. 4 per kg and the retail price is Rs. 12 per kg. The wholesale price coming down means the farmers suffer; while the consumer price index remaining stuck at the same rate despite the fall in WPI means that the consumer suffers.
In India, this padding up in profitable sectors is a common phenomenon in all businesses, whether it is agricultural products, insurance, mobile packages or others. The padding up is the result of more than necessary intermediaries in the supply chain and sharing of spoils. Is this the only way we can create jobs in our country by stuffing intermediaries into high demand sectors of the economy? (Remember ULIP?) Presently, this phenomenon is visible in the loans sector with the banks indicating a preference for distributing wholesale loans rather than retail. So, get ready to receive calls from new supply-chain intermediaries like NBFIs for personal loans rather than directly from the banks (roots of Indian sub prime?).
With the wholesale prices coming down, manufacturers and service-providers also suffer leading to salary reductions and job losses. Now, deflation in CPI due to slowdown means that the difference between the WPI and CPI reduces, leading to a reduction in the number of intermediaries, which ultimately means most jobs in the supply chain get axed, further aggravating the situation. In a way this will increase efficiency. However, deflation will ultimately lead us towards recession since this affects producers, and, there are no fiscal and monetary weapons to counter this economic phenomenon. (The only way out could be the recovery of unaccounted funds stashed away in Swiss Banks or other safe havens abroad and distributing this amongst the Indian people! Or, possibly, through the politicians distributing away all their wealth in these elections! What an idea, Sirjee!).
The next stage of this march towards recession in India will be the financial results of the corporates, which will reflect the real state of the economy. With the spending power of the consumers having reduced, the corporate results will reflect this. How can corporates be profitable in an environment of slackening demand and restricted credit flow? The Indian banks ditto since banks earn mainly through credit flows. (Is this the prime reason for delaying the results for the quarter ended March 2009?). This will lead to further job cuts and salary reductions, leading us further into slowdown. The banks will aggravate this by creating intermediaries for business and personal loans making them more expensive for consumers to make use of them. This will ultimately lead us into the recession that we are confident of avoiding (hopefully not into a sub prime crisis of our own!).
The way to sustainable economic growth and achieving the Indian economy’s potential would be to improve the quality of productive resources: 1) more productive workers with improved job skills through continuing education and training (not the socialist principle of just providing jobs); 2) proper management of available resources with policies that reduce waste and improve efficiency (not glasnost); and, 3) Investment in research and development for improvements in technologies that improve efficiency of resource utilization (human or material) and reduce our dependence on depleting natural resources (More about all this some other time). This is the route to becoming a super-power in this century not rhetoric or extreme motivation! (Jai Hind Ho!)